Archive for the ‘Equity’ Category

Dave Naffzinger’s post – Startup Stock Options: Should you Exercise your Options?is a must read post for anyone that has been granted a stock options. I’ve worked with Dave in two companies and he’s a star. This post is dynamite and while it doesn’t tell you a specific answer (there never is a "correct answer") it gives you the details you need to make an informed decision.

Jason and I welcome Matt McCall from DFJ Portage as today’s guest VC blogger. We sent Matt one of our backlog questions – his response is below. Matt also posted it on his excellent blog under the title How VC’s Determine % Ownership Thresholds.

Question: What’s a completely generic range of equity a VC typically wants for a round 1 or round 2 investment?

Most VC’s will generally say they target 20-30% ownership in a company to “make it worth their time”. This means that if they invest $3m early on, they expect the post-money to be around $10-15m and if, in later rounds, they are investing $10m, they expect to have a $30-$50m post-$.

Often, however, VC’s will use the “percentage” threshold as a means by which to increase money into a round or to get the valuation down. I have seen a given VC say they need 25% ownership for deal (to get valuation down) and do a more competitively sought deal at 15% two weeks later. In the end, two things drive all of this. First, there are legitimate minimum investment amounts a firm needs to have per deal. A $500 million fund will never get its capital deployed by doing $2m and $3m deals. They need to put $7-10m to play early and $20m+ over the life of the investment. Second, the valuation (and hence % ownership) will be driven by attractiveness and competitiveness of the deal. In the end, it is really about valuation (assuming their investment appetite remains in a set range).

Question: As a start-up with no history and no customers (we haven’t launched yet) how do I figure out how much equity to assign to myself as the founder? I have spent the last one year developing and writing the business plan. I hired two consultants both MBA’s with real world experience to help in polishing the business model and writing the plan. They agreed to do the work on contingency basis to the tune 0f $18,000 so far. I haven’t issued any shares yet. Is it paramount that I issue shares before approaching funding sources. How do I value the company? A company in similar business sold recently for over $300 million and another sold for $1.5 billion. Of course these are mature companies, but still in the same business.

Answer (Brad): If you are the only founder, the answer is simple – 100%. If there are multiple founders it’s a lot more complex and you may need to resort to arm wrestling or coin tossing. Based on your question above, it sounds like you are the only founder, so you’ll own the company until the funding event.

The actual number of shares are irrelevant – you can issue 1 (and own the 1 share – hence 100%), or issue 100 (and own 100 for the 100%), or issue 1,000,000,000 (and own 1,000,000,000 yourself – although I’d suggest this is both unnecessary and can cost you corporate taxes you don’t want in certain cases.)

Q: On average, what percentage of a company does the “typical” entrepreneur own by the time of a “successful” exit? Obviously, huge YMMW, but what’s a reasonable expectation, say, assuming two founders, middle-of-the-road terms from investors, two or three rounds of funding, and an acquisition? Or is the range so broad as to be meaningless? If so, what’s a reasonable upper bound?

A: (Brad) The short answer is “the range is so broad as to be meaningless.” I love questions that don’t have precise answers, and this is a classic one. I’ve been involved in companies where the founder equity (sum of all equity the founders have at exit) ranges from less than 5% to greater than 90%. That’s a pretty big range.

If you assume the law of large numbers, you end up with a normal curve. Without doing a detailed analysis, most of the deals I’ve been involved with where there are two founders, middle-of-the-road-terms, and two / three rounds of funding result in a tighter range – probably in the 20% – 40% range. Again – it’s a normal curve so you’ll get higher and lower cases.

(Brad) Dave Naffzinger has another excellent post up on Startup Stock Options titled Vesting Schedules & Acceleration. I’ve written about vesting plenty of times and gotten plenty of comments thanking me for the VC view but suggesting that the entrepreneurs view might be different. Dave is a co-founder and early employee of several companies – he explains why there is actually good reasons for entrepreneurs / founders to want their fellow founders to also have vesting provisions on their stock.

Q: In modeling out an early-stage deal, do you think it would be reasonable to start with a 20% option pool (Round A) and then plan to refresh that on subsequent rounds (ie, make an assumption about having key hires in place by round C or B)? Or should we just allow that option pool to get crammed down?

The starting point – on average – for an option pool after the Series A financing is 15% to 20% so this is certainly a reasonable starting point. Recognize that there is a nuance here between “pre-money” and “post-money”. I like to talk about the option pool as “post-money” so the valuation doesn’t impact the pool as part of the financing – it makes it a little simpler to discuss.

In each subsequent round, the new size of the option pool will likely be part of the financing negotiation. Most Series A investors expect you to use up most of the option pool for early hires so that when it is time to raise a new round, you’ll likely need additional options to incent your future employees. This often ends up being a three way negotiation – between the founders/management, old investors, and new investor(s). The new investor will want the options to be “pre-money” so the burden of the increase of the option pool is pushed back on the old investors and existing founders/employees; the old investor / founders want this to be “post-money” (or after the financing) so that dilution is shared by everyone, and non-founder management often are indifferent (especially if they are getting additional options in the financing), but want to make sure the size is large enough to cover the option grants they think they will need for the next wave of employees.

There is no simple rule of thumb here – it’s a negotiation. However, the amount needed to incent employees going forward is usually a number that can be determined approximately. Everyone will be incented to have the “correct amount of options” (although the definition of “correct” may vary between parties.) But – the idea that the original 20% option pool will last the entire life of a company is not logical and is pretty unusual.

Rick Segal has today’s VC Post of the Day with his excellent post A Fatal Paper Cut. Rick tells the story of the death of a promising young startup as a result of a messy early capital structure that wasn’t managed correctly from the beginning. In due diligence, the VC chickened out and the company slammed into the wall. All of this could have been avoided – documenting the early equity grants correctly and taking the capital structure seriously from the beginning would have solved all the problems. Rick gives some great suggestions for this. The VC also might have been able to get comfort with a capitalization rep from the founders, although in this case that clearly wouldn’t have done it.

This is a must read post for any entrepreneur that is setting up a new business and giving out equity grants (options or shares) of any size in exchange for services.

Beginning in 2005, Brad Feld and Jason Mendelson, managing directors at Foundry Group, wrote a long series of blog posts describing all the parts of a typical venture capital Term Sheet: a document which outlines key financial and other terms of a proposed investment...